Energy Project Risk Management

Mystery, Perception, Reality, Techniques and Psychology

Contingency Management

Chapter 7

contingency and escalation management

7.1       Misconception of Project Contingency

The word “contingency” has many meanings at different scenarios, and the cost estimate contingency owes its special definition to the world of project management and controls in large energy projects.  More often than not, the word “contingency” in Engineering, Procurement and Contracting (EPC) society has one set of meanings while its definition changes in the hands of oil producers or project owners.  Contingency has been so widely misused and misinterpreted that eventually it made many true project professionals believe that it truly is the synonym of “sludge fund” that is to be used to cover project cost overruns.  True to its definition, contingency is generated to cover the costs of intangible and uncertain items that objective and deterministic calculations may not be able to yield any meaningful answers; and it is produced through stochastic simulation method, which by definition is based on subjective judgements and good senses of heuristic factors.

It should be made absolutely clear in the first place that the estimated contingency amount in an approved budget (AFE) is not used to cover:

Major scope changes (production capacities, sizes; etc.)

  1. Major technical specification revisions and project location changes;
  2. Extraordinary events such as major civic strikes and natural disasters;
  3. Management reserves, and Escalation and currency effects;
  4. Major project schedule deferrals or slippages due to management decisions.

Contingency is, however, intended to cover normal and minor planning and estimating variability, minor omissions, slight market-driven budgetary pricing and quotation fluctuations other than general escalation, design developments other than specified design allowances, quantity variations, and small changes within the defined scope, and variations in market and environmental conditions.  Who owns the contingency and who has authority to spend it have become a hot topic among energy project managers; while the argument is never going to be settled properly, one thing is certain that the contingency is generally expected to be spent along with the other components of a cost estimate.  It is not supposed to be “saved” and given back to senior management as good project management gesture.  In other words, contingency is a genuine item in an estimate that without it the estimate will not reach the expected confidence level to meet an organization’s risk acceptance criteria or tolerance level.  

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7.2       Contingency Funds for Risk Management

The purpose of a cost risk analysis, though the result of which goes to the production of appropriate project cost contingency amount, is in reality to assist the project manager by indicating the magnitude of project risks and their severity levels, as well as where risk management efforts should be focused on if contingency is to be spent.  This practice follows the guidelines of the Pareto’s Law, and is conducted by running Monte Carlo based sensitivity analysis.  If @RISK program is utilized, a Tornado Chart is generated to illustrate the potential distribution of project cost contingency against the top ranked project risk items, measured by their regression or correlation coefficients.   

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Contingency funds, derived from quantitative risk analysis and tied to the level of risks, are used to support mitigation tasks and risk management efforts through out the project life cycle.  The contingency is gradually released during project execution, as risks have either been mitigated to completeness or have no longer had any impacts; through the draw-down process until all contingencies has been forecast to zero. It is prohibitive to have contingency draw-down plan follow project cash-flow projection[1], as contingency funds are not necessarily tied up for the duration of the project but reflected in project risk profiling.  Contingency exists for a reason and is considered as-spent dollar by the project, and it is for “in scope” risks identified through qualitative and quantitative project risk assessment workshops, therefore, contingency is specialty monetary fund designated for risk management activities, and should be used with discretion following the approved draw-down plans.

7.3       Contingency Draw-down Planning

When project cost contingency is properly simulated through CRA process, the total amount of contingency can be broken down and allocated in two ways:

-        against risk-infected accounts in the order of each account’s risk severity level measured by standard deviation and weighing factors;

-        against top risk items in the order of each individual variable’s risk severity via sensitivity analysis measured by regression coefficients;

However, cost controls of any major energy projects are time-related progression in accordance with project schedules, therefore, the contingency must be drawn down in a planned manner following project execution schedule and risk profile.  This whole process is, in energy industry, called “contingency draw-down plan”, which is to allocate and manage contingency amounts against identified risk items over the time span during when those risks are likely to consume the allocated contingency. Unconsumed contingency at the end of project will credit to overall project final forecast.  Typically the draw-down plan is plotted in graphs showing both cumulative “S” curve and incremental histogram, and the actual contingency amounts drawn down in each reporting period is also plotted in the same graphs to compare with the planned draw-downs.  The third graph, the forecasted contingency, is also shown on the same plot in addition to The Planned and The Actual contingency draw-down curves.  Three-curves provide pictorial indications of current project risk profiles by comparing contingency amount consumption.  

Figure 7-2: Contingency Distribution to Major Cost Elements (L. M. S)

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7.4       Contingency Management

Currently for major construction projects in energy industry, contingency management is handled differently between oil producers or owners and service providers or engineering, procurement and contracting (EPC) firms.  Owners oversee entire project risk profiles by monitoring total project cost over-runs or under-runs whilst EPC firms are typically held responsible for the scope they are contracted to, hence only have access to a portion of project contingency.  As contingencies are typically established based on quantitative assessment of risk exposures during projects execution phase, they can also be managed at three different levels with the modern form of P3M3 denoting Program, Portfolio and Project Management Maturity Model, which requires contingency funds to be scientifically centralized or pooled for a group of projects, and probabilistically decentralized for each individual project. However, a stand-alone project contingency and its management are highly recommended for a single mega energy project which itself could have a budget of more than $10 Billion.  This contingency is usually administered by project executive committee or senior project director and used for a broad spectrum of uncertainties within that project scope.  

According to AACEi’s contingency definition, an aggregated contingency management approach has been advocated by Mr. John Hollmann, a prominent project risk expert, and backed up by academic researches by Dr. Kujawski at Lawrence Berkeley National laboratory.  Because project contingency is the probabilistic sum of all the residual risks computed using Monte Carlo simulation, the intuitive and mathematically valid approach is to maintain a project wide contingency and distribute it to the individual risks on an as-needed basis[2]. Allocating contingency to WBS level for management may have created a false perception of control by putting funds at the disposal of the account responsibility; therefore, contingency is better managed at holistic level, or sometimes derisively called “slush fund bucket”, by senior project manager through an effective change control or trending program.  Senior PM must be immediately notified of any significant deviations from the planned paths, being cost increases or schedule slippages, so contingency funds can be activated to tackle potential risks or take corrective actions.   

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7.5       Inflation and Escalation Management

Major energy projects typically lasts a long time from engineering designs to final project completion so that cost of escalation over the time as result of the influences of inflation is inevitable. It is no surprise though escalation and inflation are sometimes interchangeably used, in reality they are two different concepts originating from different sources.  From the view point of holistic economy, inflation is defined as the overall general upward price movement of goods and services measured by the retail-based CPI (consumer price index) and capital investments related GDP (Gross Domestic Product Deflator). Inflation generally follows the supply and demand principle; if the demand becomes greater then the current workforce and manufacturing facilities can produce at their natural growth limits, inflation will generally occur.  Over time, as the cost of commodity and services increase, the actual purchasing power with the same currency face value goes down.  

Figure 7-4: Escalation Factors and the Importance of Costing Basis

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7.6       Management Reserves

Some project management books often refer to Residual Risk Reserve (R3) as Management Reserve (MR) meaning that this fund belongs to senior management in owners’ organization for discreet uses instead of automatic allocation to project execution team as part of AFE budget.   The R3 fund differs significantly from project contingency, and it is identified and established through the combination of art and science in addition to approved contingency amount.  Typically R3 is a reasonable amount of reserve funding identified, but excluded from approved project appropriation, to cover uninsurable rare-event driven risks and accepted residual risks after application of ALARP (as low as reasonably practical) principle during the execution of projects.  In some occasions, project owners may hold a pool of R3 funds as Portfolio Projects Risk Reserve to cover a group of major projects at program level,  In conclusion, R3 or MR is money set aside which is not available to the project team, that is calculated based on the Monte Carlo convolution technique of Rare Event-driven Risks or uninsurable Residual Risks using discrete probability distribution, to cope with a risk event, or the combination of them, should they arise during the course of project execution.

R3 funds against rare event-driven risks must be re-evaluated periodically as many of those discrete risks change over the time; it is recommended R3 funds are simulated every six months using Monte Carlo simulation method to include new rare risk items and/or changes of existing risks.  As the project progresses and matures, the stability of each risk assumption becomes more secure. Hence, the status of each rare risk event may change resulting in different fund requirements so the total project cost forecasts shall be updated accordingly to reflect these changes.  It must always be emphasized that Residual Risk Reserve Funds are not part of project contingency, which is considered to be spent dollars during a project life cycle, but not necessarily the R3 funds which are identified against rare risk events and presented to senior business or project management for attention only.  The rare-event driven risks typically include external uncontrollable uncertain items which generally have very low probability or frequency of occurrences, items such as unlikely union labour strikes, potential underground obstacles or found items during plant Shutdown maintenance are accounted for rare-event driven risks while residual risks may encompass further delayed equipment delivery despite mitigated expediting efforts. When these circumstances do occur in spite of their low probabilities, R3 funds would be activated through project budget change notice process and actual funds be acquired sometimes with approval from Board of Directors required.

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[1] Currently many cost analysts design contingency draw-down curve following cash-flow projection.

[2] Dr. Edouard Kujawski, Systems Engineering Department, Lawrence Berkeley National laboratory.  “why projects often fail even with high cost contingencies”.